martin wolf

How to see world economy through two crises.

My comments are written in italics.

Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one.

two different things at work. higher demand (china) and lower supply of oil causes higher costs. Federal reserve system and moral hazard by government guarantees creates unsustainable housing boom. Fractional reserve credit as provided by myriad financial institutions trying to avoid govt regulations are the weak link in the modern economy.

The place to start is with the world economy as a unit. The more globalised economies become, the more appropriate it is to think of the world economy in this way.

This seems a dangerous generalization that reminds one of Einstein’s quote to make things as simple as possible but not simpler.

The answer is that it is running into limits on resources, at least in the short term.

The fundamental state of the world is scarcity. At all times we run into limits on resources, which makes us go out to try and get more.

since the end of 2001, the real price of oil has risen some six-fold. These increases may prove temporary, as happened after the spikes of the 1970s, or permanent. We do not yet know.

We never know. Perhaps oil companies bet on governments cranking out large scale nuclear projects.

Jumps in energy prices have at least three effects on the economy.

Any change in price of a fundamental input has immense effects. It shifts the whole system to a new configuration as long as laws allow adjustment.

First, they increase headline inflation.

It would be better to differentiate between real inflation and nominal inflation, otherwise the whole thing becomes hopelessly muddled.

Second, they lower potential supply,

Potential supply? What does that mean. Potentially supply is unlimited, technology is the true limiting factor. Here it would be more helpful to say that rising energy costs just make us poorer overall.

by squeezing profits in energy-consuming activities, forcing businesses to scrap energy-intensive capacity, and making it necessary to invest in new and more energy-efficient capacity.

In its latest Economic Outlook, the Organisation for Economic Co-operation and Development discusses the consequences of such a negative supply shock on member countries**. It makes two large points: first, uncertainty about current levels and future growth of potential output has risen; and, second, the adverse effects of this may be sizeable.

Thanks OECD, captain obvious. A price change in one of the most important inputs of modern life creates uncertainty. How is uncertainty measured? Were we more certain when price was low?

The OECD estimates that the recent rise in the relative real price of oil has lowered steady-state output

Steady state output. I suggest the OECD get their noses out of their Macro 101 books and reflect upon the reality of dynamic capitalism: steady states never exist. There are no such easy to measure things as capital or labor and technology. There are just ways to do things with people and stuff, configurations of patterns that are more or less effective, cheaper and more expensive technology, constantly shifting incentives, etc.

by 4 per cent in the US and 2 per cent in the eurozone and lowered potential growth, in the medium term, by 0.2 percentage points and 0.1 percentage points, respectively. This is not trivial: in the case of the US, the decline in the growth of potential output must be at least 10 per cent of potential growth in output per head. In the more advanced emerging economies – and particularly a fast-growing industrialising economy like China – the reduction in the potential rate of growth may well be greater still.

Third, energy price jumps alter the level and distribution of global demand. The move from a price of close to $53 a barrel at the beginning of 2007 to $136 now, increases the annual cost to consumers by around $2,600bn annually, which is a tax of about 4.5 per cent on global non-oil output. Some two-thirds of this transfer is from oil-importing to oil-exporting countries. It is also from those who spend to those inclined to save, at least in the short term.

If you call pumping oil out of the ground and exchanging it for private jumbo jets saving.

This shift itself will curb the rise in global demand. So, too, will the financial crises in the US and other high-income countries and the closely related collapse of several huge house-price bubbles. In the high-income countries, growth is forecast by the OECD to slow to a little below trend this year and next. As one would expect, the biggest decline is in the US, with gross domestic product growth of 1.2 per cent this year, almost all of which is expected to be contributed by the rise in net exports. From being a locomotive of growth, the US has become dependent on growth elsewhere.

Dependent on what for what? You can only become rich by producing more value. I don’t see how producing less of value makes you “dependent on growth elsewhere”. It just means you are poorer.

Yet will this decline in the rate of growth in the high-income countries cool an overheated world economy sufficiently? Perhaps not.

Now it is suddenly good for an “overheated world economy” to “cool”. There is only more or less value produced. More is always better. There is no such thing is overheating. Unless we admit there is a problem with the way the current system functions. And there is: the financial system. It is unstable, causing games of regulation – regulation evasion, drastic shifting around of currencies, and boom – bust cycles. The recent 300 billion dollar government bailout promise to stupid and greedy home-“owners” is a good example.

Yet, as I argued last week, global monetary policy is probably too loose, despite the adverse impact of the credit crisis on high-income countries.

Isn’t it great, when our livelihoods depend on people arguing on the internet over whether monetary policy is “too loose” or not. Luckily that’s not how it works. We actually randomly pick one of the debaters and put him in charge of the printing presses and declare it the only legal currency, which can be used by governments to “buy” from the productive classes.

In many emerging countries output is growing quickly, with inflation rising strongly. If, as seems likely, the world economy cannot grow as fast as people hoped only a year or two ago, emerging economies have to be part of the adjustment. This will become still more obvious when, at last, the high-income countries recover fully.

Against this difficult background, what are the right responses and how should they be distributed, across the globe? These need to be divided into the short term and the longer term.

Let me know when we reach the long term.

In the short term, the biggest monetary policy requirement is a tightening in emerging economies, many of which now have strongly negative real interest rates. A precondition for such a tightening is a relaxation of exchange rate targeting. Monetary tightening is less obviously necessary in high-income countries, though the US Federal Reserve may have cut too far.

As important is letting the jumps in energy prices pass through, so forcing the needed adjustments in energy use.

Doing nothing is important. Which means of course, a government doing nothing, so that EVERYONE can change their behavior optimally.

The beneficiaries of the subsidies offered by many emerging countries are overwhelmingly in upper-income groups. In India, the cost of fuel subsidies is now almost as large as public spending on education: this is scandalous. No less important, however, is abandonment of the silly idea that price jumps in oil or food are the result of wicked “speculation” – a fantasy promoted by dangerous populists across the globe.

Don’t we live in a great world. Why don’t the poor also speculate themselves to riches. “speculating”, or putting your money where your mouth is regarding the future, is a great service to mankind, because it forces us ALL to adjust our present behavior to predicted future states of the world. Since people only bet when they think they can make a profit, markets will tend towards efficiency, helping us all cope with reality by following the advice of the best predictors.

Finally, it is essential for the rich countries to cushion the poorest people and countries against such shocks. The aim should be to reduce the pain and to finance necessary adjustment, but not prevent it.

Easier said than done. Development aid has consistently failed to help the poor. Post-colonial Africa is a lot worse than colonial Africa regarding cushioning, although I suppose a Mugabe does have some nice cushions in his fleet of Benzes.

In the medium to long term, the biggest priority is to release energy constraints on growth. This means increased public and private investment in energy research, particularly in renewables. The challenge is huge, but must be met.

Price rices will make people forget about their attachment to windmills. That was good in the seventeenth century. Now we need nuclear plants. Iran knows this better than we do. And they even have oil.

The shocks are large. But the more significant one is the high price of energy.

The high price of energy IS the shock.

The financial crisis was an avoidable stupidity.

If creating the Federal Reserve and a bloated Federal Government can certainly be called stupidities, but I doubt it was avoidable.

Rising prices of energy are a bitter reality. The world must adjust to this unpleasant new threat. Ideally, countries would act together. But whether they act together or not, they must act. Otherwise, greater danger – even a bad dose of stagflation – lies ahead.

Nuclear plants. Open wildlife reserves. Start offshore drilling. Or start an empire based on the protection of oil supplies.